The geopolitical environment of 2026 demands a recalibration of capital allocation strategies. For the patient capital of the Herd, analyzing the defense sector requires moving beyond headline government budget announcements.

True due diligence involves evaluating hardware manufacturing constraints, software integration capabilities, the specific index methodologies of exchange-traded funds, and the vulnerabilities of the global supply chains supporting these industries.

Executive Summary

The defense sector experienced an exceptional cycle of capital inflows during 2025, propelled by expanding global military budgets and the materialization of severe security risks across multiple continents. European nations broadly committed to raising defense spending targets, while the United States engaged in concurrent security operations spanning the Middle East, Eastern Europe, and the Indo-Pacific. This macro environment generated substantial returns for specialized investment vehicles. Specific defense-focused Exchange-Traded Funds (ETFs) operating under UCITS frameworks returned well over 50% for the calendar year, significantly outperforming their United States-listed counterparts.

However, as the global economy progresses through 2026, the variables dictating defense equity performance have grown increasingly complex. The effective closure of the Strait of Hormuz following the February 2026 escalation between the U.S., Israel, and Iran has disrupted global supply chains. This disruption impacts energy markets alongside the flow of critical industrial materials required for advanced technology manufacturing. Simultaneously, the integration of artificial intelligence into physical hardware is redefining the traditional boundaries of the defense industry. Understanding the specific methodologies of established defense ETFs, analyzing the emergence of novel funds like DRNZ and WPAI, and assessing underlying supply chain vulnerabilities remains strictly necessary for Elephants identifying long-term value in an unstable macroeconomic landscape.

The Macroeconomic Oasis: Global Trade and Inflation in 2026

The investment thesis for the defense sector in 2026 cannot rely solely on top-line revenue projections for major contractors. It requires an understanding of the interconnected risks threatening global trade, inflation, and the manufacturing base of the defense entities themselves.

The effective closure of the Strait of Hormuz in late February 2026 triggered the most severe dual-chokepoint shipping crisis in modern history.¹ When combined with ongoing disruptions in the Suez Canal corridor, roughly one-third of global seaborne crude trade became compromised simultaneously.¹ This event removed approximately 20 million barrels per day of crude oil from global markets.¹ Economic modeling indicates that if these disruptions persist, oil prices could reach between $100 and $200 per barrel, introducing massive inflationary pressures across the global economy.¹

For fixed-income markets, this resurgence of energy-driven inflation alters the trajectory of central bank interest rate policies. Elephants holding long-duration government bonds as a portfolio hedge face renewed duration risk if central banks are forced to maintain higher benchmark rates to combat supply-side inflation. Consequently, investors are increasingly looking toward tangible commodities and gold. Data from 2025 highlights this trend, with the iShares Physical Gold ETC reaching record highs and becoming a top-selling fund for investors seeking a safe haven against currency debasement.²

Geopolitical Fault Lines: The Axis of Evasion

The ongoing conflicts have accelerated the integration of an economic and technological alignment among China, Russia, and Iran. Analysts from the Atlantic Council have designated this network the “Axis of Evasion”.³ This coalition utilizes distributed supply chains and alternative financial mechanisms to maintain military production despite strict Western export controls.

Data indicates that China serves as a primary enabler by importing sanctioned Iranian oil.⁴ These purchases account for roughly 90% of Iran’s exported oil, providing Tehran with tens of billions of dollars in annual revenue.⁴ In return, Chinese entities supply sophisticated dual-use technology, electronic components, and procurement networks.⁵ This trade flow includes navigation technology alongside chemical precursors like sodium perchlorate, which is utilized in solid rocket fuel.³

Russia complements this structure by scaling manufacturing capacity, exchanging unmanned aerial vehicle technology, and providing operational data such as satellite imagery.⁵ This integration signifies that regional conflicts are sustained by a self-reinforcing production network dispersed across multiple jurisdictions to evade Western controls.⁵ For the defense sector, this structural shift guarantees elevated Western procurement spending over a multi-year horizon. Deterrence now requires countering an integrated, sanctions-resistant supply chain rather than addressing isolated state actors.

The Indo-Pacific Theater and European Rearmament

In the Indo-Pacific region, Taiwan remains a central focal point for global security and semiconductor production. Following his election victory, President Lai Ching-te announced plans to raise defense spending to 3.32% of GDP in 2026, establishing a long-term goal of reaching 5% by 2030.⁶ This initiative includes a historic $40 billion supplementary defense budget spread over eight years, designated under the Special Act on Procurement for Enhancing Defense, Resilience, and Asymmetric Capabilities.⁶

However, Taiwan’s domestic political reality presents substantial execution risks. The ruling Democratic Progressive Party lost its parliamentary majority during the last election cycle, resulting in a divided government.⁷ In early 2025, the opposition-controlled Legislative Yuan approved unprecedented budget cuts totaling 6.6% of the proposed budget, significantly reducing allocations for defense funding.⁷ The market is actively pricing in the outcome of the August 2026 Taiwan referendum, which will address domestic issues and the potential reactivation of nuclear power.⁸ This political gridlock occasionally delays contract execution, resulting in uneven revenue recognition for United States defense contractors relying on Foreign Military Sales to Taipei.

Simultaneously, the European theater has undergone a historic acceleration in military procurement. The 32 NATO alliance countries lifted their target for defense spending to 5% of gross domestic product by 2035.⁹ This policy shift transforms European defense spending from a reactive measure into a structural pillar of government budgets.¹⁰ Germany’s implementation of a 500 billion Euro infrastructure and modernization fund explicitly supports its expanded military commitments, providing immense backlog visibility for continental hardware manufacturers.¹¹

Supply Chain Vulnerabilities: Foraging for Critical Minerals

A record order backlog is entirely irrelevant if raw materials cannot be sourced to manufacture the final product. The most significant vulnerability for the global defense industry in 2026 lies deep within its supply chain. Thick-skinned investors must evaluate contractors based on their supply chain resilience rather than their top-line revenue projections.

The Strait of Hormuz closure impacts the defense and advanced technology sectors far beyond fuel costs. The Middle East is a central hub for industrial materials essential to semiconductor and aerospace manufacturing. Qatar provides more than 25% of the global helium supply, a gas strictly required for cooling equipment used in semiconductor fabrication.¹² Furthermore, the region accounts for nearly half of the global trade in sulfur.¹² Ultra-high-purity sulfuric acid is utilized in semiconductor manufacturing for wafer cleaning processes. General sulfur serves as a primary reagent for extracting metals from sulfide ores, including copper, nickel, zinc, and cobalt.¹²

The disruption of these inputs, combined with the reduction in major refined oil production, places severe constraints on the supply chains of defense contractors.¹² Asian economies anticipate a 30% reduction in refined oil output, while Chinese output may fall by 50% to 70%.¹²

A March 2026 report by the Aerospace Industries Association mapped the acute vulnerabilities specific to the United States defense supply chain. The report provides a stark assessment: “The U.S. is 100% import-reliant on manganese, gallium, tantalum, yttrium, and titanium sponge, with over 75% reliance on magnesium, cobalt, tungsten, and rhenium”.¹³

China controls an estimated 70% of rare earth permanent magnet processing and has recently demonstrated a willingness to weaponize these supply chains through targeted export controls on gallium, germanium, and antimony.¹³ The global titanium landscape relies heavily on production from geopolitical rivals. While European entities have made efforts to compensate for the loss of specific regional supplies, Russia continues to hold significant influence as the world’s largest producer of aviation-grade titanium.¹⁴ Companies lacking robust, allied-sourced material agreements face immediate margin compression and extended delivery timelines.

Analysis of US Defense ETFs: Weighing the Methodologies

The United States market offers several established defense Exchange-Traded Funds. Their internal index methodologies yield vastly different exposures, preventing them from performing uniformly during market cycles. Understanding these mechanics is a prerequisite for any Elephant conducting portfolio due diligence.

The following table highlights the top-performing U.S.-listed defense ETFs based on their 2025 annual returns.

ETF Name	Ticker	2025 Return	Weighting Methodology	Top 10 Concentration
ARK Space & Defense Innovation	ARKX	48.28%	Active Management	N/A
First Trust Indxx Aerospace & Defense	MISL	26.65%	Modified Market Cap	62.42%
SPDR S&P Aerospace & Defense	XAR	18.71%	Equal Weight	31.63%
Invesco Aerospace & Defense	PPA	13.65%	Modified Market Cap	61.53%
iShares U.S. Aerospace & Defense	ITA	12.55%	Market Cap	>54.00%

Source Data: ¹⁵

ARK Space & Defense Innovation ETF (ARKX)

The top performer in the U.S. category for 2025 was the ARK Space & Defense Innovation ETF, which generated a 48.28% return.¹⁶ Unlike its passively managed peers, ARKX utilizes active management to target companies engaged in space exploration, orbital aerospace, and advanced defense technologies.

The fund’s active management allows it to capture growth in adjacent tech sectors, avoiding legacy hardware manufacturers that suffer from slow procurement cycles. However, the fund carries a higher expense ratio typical of active management. Analysts have assigned it a Negative Morningstar Medalist Rating, expressing deep skepticism regarding its ability to consistently deliver positive risk-adjusted returns after fees over a long-term horizon.¹⁶

SPDR S&P Aerospace & Defense ETF (XAR)

XAR tracks the S&P Aerospace & Defense Select Industry Index and employs a strict equal-weight methodology.¹⁹ It delivered an 18.71% return in 2025.¹⁸

By allocating roughly the same weight to each of its 40 holdings, XAR neutralizes the dominance of mega-cap prime contractors.¹⁹ This provides investors with significantly higher exposure to mid-cap and small-cap companies.¹⁹ These smaller firms frequently operate as pure-play aerospace component manufacturers. During periods of elevated merger and acquisition activity, these smaller firms become prime acquisition targets, potentially generating alpha for the fund. Conversely, equal weighting forces the fund to allocate capital to smaller firms that often carry higher debt loads. In the high-interest-rate environment of 2026, these smaller constituents may struggle with elevated borrowing costs and severe supply chain constraints.

Invesco Aerospace & Defense ETF (PPA)

PPA tracks the SPADE Defense Index and uses a modified market-cap weighting approach.¹⁹ It returned 13.65% in 2025.¹⁸

The SPADE methodology caps the influence of the absolute largest companies, resulting in a more balanced portfolio than a pure market-cap index.¹⁹ With 61 holdings, it offers broad diversification across the domestic defense industrial base.²⁰ Its top holdings include Lockheed Martin at 9.39%, RTX at 8.73%, and General Electric at 7.63%.¹⁹ It successfully captures the stability of the major prime contractors while retaining meaningful exposure to secondary suppliers. At 0.58%, its total expense ratio is slightly higher than competing passive alternatives.²⁰ It remains a heavily concentrated trade, with over 61% of its assets secured in the top ten holdings.¹⁷

iShares U.S. Aerospace & Defense ETF (ITA)

While ITA stands as the largest defense ETF by assets under management with over $16.4 billion, its 2025 performance lagged its peers at 12.55%.¹⁵

ITA tracks the Dow Jones U.S. Select Aerospace & Defense Index using a pure market-cap weighting methodology.¹⁹ This structure results in extreme concentration. At times, its top three holdings – GE Aerospace, RTX, and Boeing – account for vast portions of the portfolio.¹⁹ By March 2026, GE Aerospace represented 19.00% of the fund, followed by RTX at 16.44% and Boeing at 8.65%.¹⁹ Consequently, operational failures or commercial aviation downturns affecting a single mega-cap stock can severely drag down the entire ETF’s performance. The fund’s heavy reliance on commercial aerospace recovery leaves it vulnerable to non-defense market shocks.

Analysis of UCITS Defense ETFs: The European Stampede

The European UCITS market witnessed an explosion of defense-themed ETFs over recent years, heavily driven by the continent’s immediate requirement to rearm following the outbreak of war in Eastern Europe. The top UCITS funds significantly outperformed their U.S. counterparts in 2025, largely due to their exposure to European contractors experiencing historic order backlog growth.

The table below outlines the performance metrics for the leading European-domiciled defense ETFs.

ETF Name	Ticker	2025 Return	TER	Base Currency
VanEck Defense UCITS ETF	DFNS	68.81%	0.55%	USD
Global X Defence Tech UCITS ETF	ARMR	57.33%	0.50%	USD
iShares Global Aerospace & Defence	DFND	54.60%	0.35%	USD
First Trust Indxx Global Aerospace	MISL	45.27%	0.65%	USD
Invesco Defence Innovation UCITS ETF	IDFN	38.28%	0.35%	USD

Source Data: ²¹

VanEck Defense UCITS ETF (DFNS)

The definitive leader in the UCITS space for 2025 was the VanEck Defense UCITS ETF, generating an exceptional 68.81% return.²¹ Since its inception, the fund has maintained an annualized performance of 49.68%.²¹

DFNS passively tracks the MarketVector Global Defense Industry Index.²¹ It focuses on companies deriving significant revenue specifically from the defense sector, maintaining a strict global posture. This global mandate allowed it to capture the upside of European defense contractors – such as Rheinmetall and Thales – which saw massive valuation re-ratings as NATO members pushed toward the 5% GDP defense spending targets.¹⁹ The fund is highly cyclical and sensitive to shifts in European political consensus. A diplomatic resolution to ongoing continental conflicts could trigger a rapid valuation compression across its primary holdings.

Global X Defence Tech UCITS ETF (ARMR)

Generating a 57.33% return in 2025, ARMR offers a differentiated approach by prioritizing technology over traditional heavy metal manufacturing.²³

ARMR targets companies positioned to benefit from defense technology adoption, including cybersecurity networks, artificial intelligence, advanced robotics, and data analytics.²⁴ Its top holdings typically include Lockheed Martin, Northrop Grumman, BAE Systems, and Palantir Technologies.²⁵ By focusing on the technology stack, ARMR aligns perfectly with the future of warfare, which prioritizes electronic warfare, secure communications, and AI targeting over conventional platforms.²⁴ The inclusion of broad technology and cybersecurity firms means the fund’s performance is partially tethered to the broader tech sector’s valuation multiples, exposing it to interest rate sensitivity.

iShares Global Aerospace & Defence UCITS ETF (DFND)

DFND returned 54.60% in 2025.²² Launched in early 2024, it quickly gathered over $1.4 billion in assets under management.²⁶

The fund replicates the S&P Developed BMI Select Aerospace & Defense Capped Index.²⁶ It holds 77 constituents across developed markets, applying a capping mechanism to ensure diversification.²⁶ At 0.35%, it offers one of the lowest total expense ratios in the UCITS defense category.²⁶ Its capping methodology effectively prevents the extreme top-heaviness seen in U.S. market-cap funds. It excludes emerging market defense contractors entirely, potentially missing massive revenue growth in regions like South Korea, which has rapidly become a major arms exporter.

The Next Generation: WPAI, DRNZ, and Embodied Intelligence

As the defense sector evolves, traditional industry classifications become increasingly obsolete. Two new ETFs launched recently – DRNZ and WPAI – illustrate the market’s aggressive shift toward highly specialized, technology-driven hardware. These funds represent a departure from legacy prime contractors, focusing entirely on autonomous systems and robotics.

DRNZ: The REX Drone ETF

Launched in October 2025, DRNZ serves as the first pure-play fund to focus specifically on the global drone and Unmanned Aerial Vehicle (UAV) economy.²⁹

DRNZ tracks the VettaFi Drone Index utilizing a modified free-float market capitalization methodology.²⁹ The strategy demands allocating at least 80% of the portfolio to pureplay drone companies, defined as firms deriving over 50% of revenue from drones or enabling technologies.²⁹ These pureplay constituents are subject to a strict 15% weight cap to maintain structural balance. The remaining 20% of the index is allocated to diversified companies possessing at least 20% drone revenue, capped at 5% each.²⁹ As of March 2026, its top holdings include drone defense firm DroneShield at 12.07%, Ondas Holdings at 10.85%, and military drone manufacturer AeroVironment at 7.87%.²⁹

DRNZ successfully bridges the structural gap between military and commercial applications. Drones are no longer exclusively defense assets; they are central to logistics, agriculture, and infrastructure inspection.²⁹ By capturing both markets, DRNZ provides a partial hedge against defense budget contraction cycles. The heavy concentration in small-to-mid-cap technology hardware firms introduces high beta and significant price volatility. The drone market remains highly sensitive to export controls and technology sanctions, presenting severe regulatory risks.

WPAI: WisdomTree Physical AI, Humanoids and Drones UCITS ETF

Launched in February 2026 on European exchanges, WPAI represents a massive conceptual shift in thematic investing by focusing entirely on the concept of “Physical AI”.³¹

WPAI tracks the WisdomTree Physical AI UCITS Index with a total expense ratio of 0.45%.³² The methodology evaluates companies across five distinct categories: humanoid robotics, autonomous mobility, smart manufacturing, next-generation logistics, and emerging applications.³⁴ The index employs a unique dual-scoring system. Each category is assigned a Thematic Score reflecting its significance to the advancement of Physical AI.³⁴ Simultaneously, each company receives a Relevancy Score reflecting its direct involvement.³⁴ The final index is equally weighted, but numerically adjusted by these combined scores.³⁴ Geographically, the fund allocates heavily to the United States (42.99%), China (16.13%), and Japan (14.54%), holding 61 constituents in total.³⁵

WPAI identifies a critical transition in the technology sector: the movement of artificial intelligence from digital, cognitive tasks to embodied intelligence that interacts physically with the real world.³⁶ As one Baillie Gifford analysis notes, “Physical AI is broader, more accurate, and less emotive. It encompasses all systems where intelligence meets motion, controlling machines in the real world.”.³⁷ This transition is heavily funded by defense agencies seeking autonomous systems, making WPAI a stealth defense play. Its primary weakness lies in its exposure to geopolitical trade friction. With over 16% exposure to China, the fund holds assets directly targeted by Western technology export controls, tariffs, and military sanctions.³⁵

Counter-Arguments: Valuations, Passive Flows, and ESG Taxonomy

While the fundamental drivers for the defense sector appear robust, Elephants must evaluate the structural risks and counter-arguments that could derail long-term returns. The current environment presents several distinct threats to defense equity valuations.

The Illusion of Passive Stability and the Crowded Trade

The exceptional returns of defense ETFs during 2024 and 2025 attracted vast amounts of passive capital. By August 2025, industrial ETFs saw $5.5 billion in net inflows, with 88% directed specifically into funds carrying “defense” in their name.¹¹

This dynamic creates a structural valuation risk. The valuations of the absolute largest defense stocks are sustained in part by these mechanical passive inflows, fueling severe market concentration.³⁸ If geopolitical tensions momentarily cool, or if the August 2026 Taiwan referendum results in a more conciliatory regional posture, passive flows could abruptly reverse direction.³⁸ Because the sector has evolved into a highly crowded trade, a flow reversal could initiate a self-reinforcing downward spiral, disproportionately impacting market-cap-weighted ETFs like ITA.³⁸ Defense equities historically revert to their long-term mean valuation trends following periods of acute conflict enthusiasm.¹⁵

The ESG Debate and the European Social Taxonomy

A major structural force affecting European defense stocks is the ongoing debate regarding their classification under Environmental, Social, and Governance frameworks. Historically, many institutional funds excluded defense assets entirely due to ethical mandates. The current requirement for national resilience has prompted a contentious reevaluation of what constitutes a sustainable investment.⁴⁰

The European Commission has recently clarified that the EU Taxonomy does not automatically exclude defense financing, provided the investments support broader sustainability objectives like societal stability or national resilience.⁴⁰ However, the classification of controversial weapons remains highly fragmented across the financial industry. Differing methodologies between data providers mean a company might be flagged for controversial weapons involvement by Sustainalytics but cleared entirely by Bloomberg.⁴²

Intense pressure from industry groups seeks to classify defense as a sustainable investment under the Sustainable Finance Disclosure Regulation to foster easier financing and secure institutional capital.⁴¹ ESG advocates and organizations like Finance Watch argue that defining defense as sustainable by default distorts labeling, reduces trust, and fundamentally undermines environmental objectives.⁴¹ For investors, this regulatory uncertainty means that European defense equities may experience sudden influxes of passive capital if classification rules are formally relaxed, altering their valuation dynamics independently of actual corporate earnings. Conversely, if ESG rules harden against defense inclusion, European contractors may face higher costs of capital compared to their American peers.

Elephant Conclusions for the Herd

The defense sector in 2026 presents a highly complex environment requiring deep, methodical due diligence. The era of assuming broad defense ETFs will automatically rise on generic geopolitical headlines has definitively passed. The market has entered a phase where supply chain mechanics and technological specialization dictate long-term value.

First, index methodology matters immensely. The Herd must look closely under the hood of their chosen ETFs. Market-cap weighting provides high liquidity but dangerous concentration in legacy prime contractors. Equal weighting reduces concentration risk but increases exposure to vulnerable smaller firms struggling with elevated debt costs. Modified weighting approaches offer a necessary middle ground for long-term holds.

Second, supply chains dictate actual corporate value. Geopolitical tensions, specifically the Strait of Hormuz closure and the integrated evasion tactics of adversarial nations, are actively restricting the supply of helium, sulfur, and critical rare earth minerals. Record defense budgets approved by governments cannot be realized as corporate revenue if contractors physically cannot source the materials to build the hardware.

Third, the nature of defense hardware is fundamentally changing. The emergence of DRNZ and WPAI highlights the rapid convergence of traditional defense contracting, commercial robotics, and artificial intelligence. The future of the sector lies in physical AI and embodied intelligence.

Finally, beware the crowded oasis. The massive influx of passive capital into defense ETFs over the last two years has stretched historical valuations. Thick-skinned investors must exercise patience, maintaining a long-term perspective focused on supply chain resilience rather than chasing immediate gains following episodic geopolitical escalations. The most successful allocations will balance exposure to reliable, well-capitalized prime contractors with the targeted inclusion of the emerging physical AI firms that will define the next generation of global security.

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